It is no secret that Indian banks’ treasury income, which contributed handsomely to their profit in calendar year 2016 as bond prices rose and yields fell, has been substantially eroded since January. The yield on the benchmark 10-year paper rose 29 basis points during the last quarter of fiscal year 2017, from 6.4% on 1 January to 6.69% on 31 March. One basis point is a hundredth of a percentage point. Many banks would probably end up booking treasury losses in this quarter. The 10-year yield has risen further in the past fortnight to 6.78% and will probably remain range bound in the first quarter of the current fiscal year.

While the focus is on the rise of bond yields and erosion in banks’ treasury profits, many are missing an interesting development—the intense fight between the bulls and the bears in the Indian bond market, aggressive short-selling by some of the foreign banks and primary dealers, and the counter-attack by some of the state-run banks, leading to the so-called short squeeze. The primary dealers buy and sell government bonds while foreign banks, like all other banks operating in India, need to have a mandatory bond portfolio to the extent of 20.5% of their net demand and time liability (NDTL), a loose proxy for deposits. However, unlike the state-owned banks, they buy shorter maturity bonds and continuously trade to make profits.

Twice in the recent past—in the first week of March and again in the first week of April 2017—the stability of the market was threatened. But for the banking regulator’s intervention, some of the foreign banks and primary dealers could have defaulted, leading to chaos in the bond market.

A short sale is a transaction in which a trader sells a bond which it does not own. So, the trader borrows from others to meet its delivery obligations to the Clearing Corp. of India Ltd (CCIL), which runs the bond market, till it buys the bonds and squares off the position. The banks and the primary dealers resort to short selling when their view is bearish—that is, the prices of the bond will fall and the yield will rise. They make money if the bond prices drop. In contrast to that, those who hold long positions make money when the bond prices go up. A short squeeze happens when there is a lack of supply of the bond which the short sellers need to borrow.

In the two instances in March and April, the public sector banks, led by a very large bank, refused to lend bonds to the foreign banks and primary dealers for covering in the Clearcorp Repo Order Matching System or CROMS platform of CCIL, even though the short sellers were ready to pay a hefty price for it. Had the public sector banks, which allegedly formed a cartel to teach the short sellers a lesson, stuck to their stand, then the short sellers would not have been able to cover their short positions and defaulted—something that never happened in the history of the Indian bond market.

Before we delve deep, let’s first take a look at how the bond market operates in India. CCIL runs the cash market, where the daily average volume is around Rs30,000 crore. The future market, a much thinner market and a relatively new one, is run by stock exchanges. On the lines of most international markets, CCIL follows the so-called T+1 settlement system—the settlement happens a day after the transaction takes place.

One can resort to short selling intra-day (meaning covering the position on the same day) but can also keep it open overnight if the view is that the prices will drop further the next day. Short selling is an accepted market practice but there are limits to what extent one can go short. For instance, for an illiquid bond—which does not see much trading—the limit is capped at 0.25% of its outstanding stock. This means, if the outstanding security stock is Rs10,000 crore, one can short sell up to Rs25 crore. For a liquid security, the ceiling is higher—0.75% or Rs600 crore, the lower of the two.

A short seller borrows the security from others in the market through the so-called repo or repurchase deals on the CROMS platform of CCIL. One can borrow the security for one day and keep on rolling it over up to 90 days till one actually buys the security. However, typically, the short sellers do not keep the position open for more than a fortnight. In other words, for two weeks, they keep on rolling over their borrowed security from the repo market.

For the repo deal, the bank which lends the bonds gets money in lieu of that and, of course, it needs to pay interest on that money. Typically, the interest rate for such deals is slightly lower than the overnight call money rate, around 4.5% at this time. However, the short sellers—desperate to borrow security—were willing to give the money (and borrow securities) almost free, at an interest of 0.01%! Still, the public sector banks holding the securities were not willing to lend the bonds to them as they felt the short sellers were instrumental in pushing the bond prices down.

A drop in bond prices hurts the banks as they need to mark to market (MTM) or value a substantial portion of their bond portfolio in accordance with the market price and not the prices at which they were bought historically. Even though the banks in India need to have a mandatory investment of 20.5% of their deposits in government bonds, many banks, particularly the state-run ones, hold more; the average bond holding in the industry could be around 26%. The mandated holding of 20.5% can be kept in the so-called held to maturity, or HTM segment, which does not need to be marked to market; but the rest of the portfolio can be kept in a combination of the so-called available for sale (AFS) and held for trading (HFT) baskets, and it needs to be valued in accordance with the prevailing market price, or marked to market. Foreign banks too are subject to the same regulations but typically, they mark to market their entire bond portfolio.

Indeed, short selling is the lifeblood for the development of any securities market as it creates liquidity and helps in price discovery. Long-only players alone cannot add depth to the market. But, how do we prevent recurrence of such incidents in the future and keep the bond market stable and growing? Is the regulator’s intervention ideal in such a situation? Doesn’t it spoil the spirit of the free market? Similarly, some market players can certainly refuse to lend security to the short sellers but can they do it en masse by forming a cartel? I understand that a deputy governor of the Reserve Bank of India (RBI) held a meeting with some of the foreign banks and primary dealers and told the public sector banks to make the securities available for lending or else face penalty.

One way of tackling this could be, allowing more players such as mutual funds and insurance companies in the repo market. If that happens, certain banks cannot dictate terms and there will be more entities to take care of the supply of bonds.

Another option could be, allowing repo transactions at negative interest rates. Anyway, the short sellers are taking risks to make profits and they must be prepared to pay a price. They were ready to give money at 0.01% for bonds in the first week of April. Negative interest will make the transaction even costlier for them but there is no harm as they are ready to take risks to make money. RBI can also supply bonds in the repo market to the short sellers if it has the stock.

Finally, we need to develop the futures market. Once the futures market is deep and wide enough, the short sellers will be able to arbitrage between the two markets. Right now, stiff stamp duty adds to the transaction costs in the futures market. As a result of this, the futures market—which is meant to attract retail investors—does not even see too many institutional players. I understand that some banks, who have become members of the exchanges, have found ways to avoid payment of stamp duty. Currently, the non-members need to pay stamp duty. Even the members may ultimately have to pay—as and when the Maharashtra government wakes up.

Tamal Bandyopadhyay, consulting editor at Mint, is adviser to Bandhan Bank. He is also the author of A Bank for the Buck, Sahara: The Untold Story and Bandhan: The Making of a Bank.